Introduction to Cost-Benefit Analysis: Using Market Prices Presentation by Dr. Benoit Laplante Environmental Economist Consultant Asian Development Bank Bangkok September 30 to October 4, 2013 PRDEI, December 18, 1996 41

Outline of Presentation 1. Cost-benefit analysis: 8 steps 2. Quantifying the impacts of a project 3. Concept of economic value 4. Methodologies to evaluate impacts 5. Using market prices 2

Outline of Presentation 1. Cost-benefit analysis: 8 steps 2. Quantifying the impacts of a project 3. Concept of economic value 4. Methodologies to evaluate impacts 5. Using market prices 3

Cost-benefit analysis: 8 steps Step 1: Define the scope of analysis. Step 2: Identify all potential physical impacts of the project. Step 3: Quantify the predicted impacts. Step 4: Monetize impacts. Step 5: Discount to find present value of costs and benefits. Step 6: Calculate net present value. Step 7: Perform expected value and/or sensitivity analysis. Step 8: Make recommendations. 4

Cost-benefit analysis: 8 steps Step 1: Define the scope of analysis. Step 2: Identify all potential physical impacts of the project. Step 3: Quantify the predicted impacts. Step 4: Monetize impacts. Step 5: Discount to find present value of costs and benefits. Step 6: Calculate net present value. Step 7: Perform expected value and/or sensitivity analysis. Step 8: Make recommendations. 5

Quantifying the impacts of a project This is perhaps the most important and most common failure in CBA. 6

Quantifying the impacts of a project Suppose the following (hypothetical) situation: In a specific region of the country, agricultural yield has been going down for the last few years (which may or may not be related to climate change). Projected increases in air temperature is expected to have an adverse effect on agricultural yield. Suppose a project (for example a supplementary irrigation project) which aims to offset some or all of this adverse affect. How would one assess the impact of the project on agricultural yield given the projected increases in air temperature? In other words: How would one assess the benefits of this project?

Quantifying the impacts of a project Yield (tons per month) Which question do we need to ask to quantify the possible impacts of the project? Question 1: What is likely to happen WITHOUT the project? Existing yield Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project Yield (tons per month) Existing yield Suppose this is estimated yield given projected increases in temperature WITHOUT project. Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project Yield (tons per month) Question 2: What would be ag yield given projected increases in temperature WITH the project? Existing yield Suppose this is estimated yield given projected increases in temperature WITHOUT project. Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project Yield (tons per month) Question 2: What would be ag yield given projected increases in temperature WITH the project? Existing yield Suppose this is estimated yield given projected increases in temperature WITH project. Impact of project Suppose this is estimated yield given projected increases in temperature WITHOUT project. Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project Yield (tons per month) Under PPCR, the baseline is the value of the existing yield at the time the PPCR is negotiated. Existing yield Suppose one goes back a few years later and find this. What will PPCR conclude? Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project Yield (tons per month) Under PPCR, the baseline is the value of the existing yield at the time the PPCR is negotiated. Existing yield Suppose one goes back a few years later and find this. PPCR will conclude project is a failure. But in fact, if this was without project, then the project is a success. Past Today Looking in the future Time PRDEI, December 18, 1996 41

Quantifying the impacts of a project This is perhaps the most important and most common failure in CBA. We must always ask: What would happen if the project did not take place. We must compare how the situation will be “with the project” and how it is expected to be “without the project”.

Outline of Presentation 1. Cost-benefit analysis: 8 steps 2. Quantifying the impacts of a project 3. Concept of economic value 4. Methodologies to evaluate impacts 5. Using market prices 15

The concept of economic value Consider an individual in an initial state of well-being W0 that he/she she achieves with a money income Y0 and a level of access to irrigation IR0: W0 (Y0, IR0) Now consider a project which would increase access to irrigation water to IR1. This increased access to IR would produce a new level of well-being to W1: W1 (Y0, IR1) Since this individual’s well-being would increase with the project, we know that: W1 (Y0, IR1) > W0 (Y0, IR0) PRDEI, December 18, 1996 41

The concept of economic value In order to assess the appropriateness of this project and compare the costs of the project with the benefits, we would like to know how much the well-being of this individual is increased with increased access to irrigation, i.e. how large is W1 minus W0? ΔW = W1 (Y0, IR1) - W0 (Y0, IR0) How could we measure this change in well-being? How large is W1 minus W0? PRDEI, December 18, 1996 41

The concept of economic value Determine the maximum amount of income the individual would be willing to pay (WTP) for the change in IR. In effect, the individual is asked to consider two combinations of income and access to irrigation water that both yield the same level of well-being: One combination in which his/her income is reduced and access to IR is increased; and Another combination in which income is not reduced and access to IR remains the same as it is (no change). W0 (Y0, IR0) = W0 (Y0 – WTP, IR1) PRDEI, December 18, 1996 41

The concept of economic value W0 (Y0, IR0) = W0 (Y0 – WTP, IR1) WTP is defined as the amount of money that makes these two combinations of income and traffic congestion yield the same level of well-being. This is the maximum the individual would be willing to pay for the positive change in welfare resulting from a greater access to irrigation water. This maximum WTP is defined as the economic value of the change in well-being resulting from the increased access to irrigation water from IR0 to IR1. All economic valuation methodologies aim to measure this maximum WTP. Some methodologies do this well, some not so well. PRDEI, December 18, 1996 41

The concept of economic value Total economic value Use value Non-use value + Indirect use value + Direct use value Bequest value Existence value + Consumptive direct use value Non-consumptive direct use value + Among use value, we also add: Option value Relatively easy to measure Relatively difficult to measure

Outline of Presentation 1. Cost-benefit analysis: 8 steps 2. Quantifying the impacts of a project 3. Concept of economic value 4. Methodologies to evaluate impacts 5. Using market prices 21

Methodologies to evaluate impacts 22

Methodologies to evaluate impacts Use value Group 1: Change of productivity methodology Direct use value Consumptive direct use value Non-consumptive direct use value Group 2 (Revealed preferences) and Group 3 (Stated preferences) Indirect use value Non-use value Bequest value Group 3 (Stated preferences) Existence value

Methodologies to evaluate impacts Use value Group 1: Change of productivity methodology Direct use value Consumptive direct use value Non-consumptive direct use value Group 2 (Revealed preferences) and Group 3 (Stated preferences) Indirect use value Non-use value Bequest value Group 3 (Stated preferences) Existence value

Outline of Presentation 1. Cost-benefit analysis: 8 steps 2. Quantifying the impacts of a project 3. Methodologies to evaluate impacts 4. Using market prices 25

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology This methodology is generally applied in the specific case where the environmental impact represents a change in a component of the environment (or ecosystem) which has a direct consumptive value. This impact will be measured by a change in the production of a good for which there is already a market, and therefore market prices. Market prices or shadow prices will be used to assess the economic impact of this change in productivity. PRDEI, December 18, 1996 41

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology Examples where appropriate to use this methodology: Water pollution may impact fisheries yield; Reservoir sedimentation may impact power production; Floods may impact agriculture production; Increases in temperature may reduce agricultural yield. PRDEI, December 18, 1996 41

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology Proceeds in two steps: Step 1: Establish the link or the relationship that exists between a change in environmental quality and the resulting impact on production. This is generally called a dose-response function. Examples of dose-response functions: Relationship between fisheries yield and water pollution; Relationship between reservoir sedimentation and power production; Relationship between temperature and agricultural production. PRDEI, December 18, 1996 41

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology Proceeds in two steps: Step 2: Once the change in production is established, market prices (or shadow prices which are market prices corrected for the presence of subsidies, taxes or for any other market imperfections) are then used to estimate the economic value of the estimated change in production. PRDEI, December 18, 1996 41

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology Proceeds in two steps: Step 1: Establish the link or the relationship that exists between a change in environmental quality and the resulting impact on production. Step 2: Once the change in production is established, market prices (or shadow prices which are market prices corrected for the presence of subsidies, taxes or for any other market imperfections) are then used to estimate the economic value of the estimated change in production. Step 1 is the difficult step. PRDEI, December 18, 1996 41

Cost-benefit analysis: 8 steps Step 1: Define the scope of analysis. Step 2: Identify all potential physical impacts of the project. Step 3: Quantify the predicted impacts. Step 4: Monetize impacts. Step 5: Discount to find present value of costs and benefits. Step 6: Calculate net present value. Step 7: Perform expected value and/or sensitivity analysis. Step 8: Make recommendations. 31

Steps and expertise Need multi-disciplinary team IDENTIFICATION OF IMPACTS Task of technical and scientific experts Task of technical, scientific and economic experts QUANTIFICATION OF IMPACTS ECONOMIC VALUATION OF IMPACTS Task of economists Need multi-disciplinary team PRDEI, December 18, 1996 41

Group 1: ‘Change of productivity’ methodology Using market prices Group 1: ‘Change of productivity’ methodology Suppose the following example: A project developer proposes to open a factory which would produce water pollution (or logging which is going to produce soil erosion). Downstream the factory location, local communities are undertaking traditional fishing activities. Discussion with the community leaders reveal that for the last 5 years, there were approximately 200 fishermen. Over that period of time, fisheries yield has ranged between 300 and 400 tons per year. The market price of the fish is $ 10,000 per ton. Average local wage for non-skilled labor in the area is approximately $ 800 per month. Based on the experience of similar industrial activities in other similar areas, it is expected that fisheries will completely disappear over a period of approximately 10 years as a result of the pollution. Once gone, fish will never come back. PRDEI, December 18, 1996 41

Introduction to Cost-Benefit Analysis: Using Market Prices Presentation by Dr. Benoit Laplante Environmental Economist Consultant Asian Development Bank Bangkok September 30 to October 4, 2013 PRDEI, December 18, 1996 41